Yahoo-Microsoft: Playing the Yahoo Earnings Chess Game

This week is crucial for the Yahoo-Microsoft takeover battle. Yahoo's earnings report will likely shift the balance of negotiating power one way or the other--forcing Yahoo (YHOO) into a fire sale or forcing Microsoft (MSFT) to raise its price or abandon its pursuit of the company.

Here are some of the possible moves and counter-moves:

ACTION 1: Yahoo blows Q1 and/or provides a disappointing outlook. "Blowing Q1" in this scenario would mean delivering revenue or earnings
in the lower half of the forecasted range OR hitting the high-end of
the range but not raising guidance for the full year. This is unlikely, in our opinion. If Yahoo's business has deteriorated, the board would be nuts not to already be negotiating seriously with Microsoft.

OUTCOME: Yahoo's shareholders scream bloody murder, Yahoo's board capitulates under the threat of a Microsoft bid cut, and a deal is struck relatively rapidly at the original bid (which is currently worth $29.76, according to our bid calculator)

ACTION 2: Yahoo delivers a strong Q1 and raises guidance appropriately. This iikely, in our opinion. Again, if Yahoo isn't in a position to deliver this, it should have started negotiating months ago.

OUTCOMES:

Yahoo will make a credible argument that it is worth more than when Microsoft made its bid and therefore deserves a higher bid. Lots of Yahoo shareholders, the press, the public, and common sense will support this view, especially because so many stories circulated after the original bid saying that Microsoft had been prepared to pay $35, but had lowered its bid after Yahoo's weak Q4.

Microsoft will argue on background that Yahoo only made the quarter by burning the furniture and that Q2 will be weak. Microsoft will say that its valuation of Yahoo wasn't based on one quarter or year and that the increase in outlook doesn't change "full and fair value."

No one will really buy Microsoft's argument. Everyone will now think a price increase is only fair--especially if, as is also possible, Yahoo announces a search deal with Google.

On Wednesday, after the earnings report, Yahoo will tell Microsoft it is happy to negotiate if Microsoft raises its bid, thus not appearing to blow off Microsoft's Saturday deadline.

NEXT MOVES: Assuming scenario 2 is what happens, as we expect it will, the next move will be Microsoft's. In our opinion, Microsoft will have several options:

Do nothing, continue to wait. Unlikely. By threatening Yahoo two weeks ago, Microsoft has taken "the waiting game" off the table. If Microsoft doesn't act on its own Saturday deadline, it will be announcing to Yahoo and the world that nothing it says should be taken seriously.

File slate of directors and exchange offer and prepare for proxy fight. Possible, but not the most likely option. If Yahoo has a strong earnings call, the proxy-fight route will be more challenging. Some Yahoo shareholders will hold out for a price increase, and when this voting power is combined with that of Jerry, Dave, and other insiders, winning a proxy vote at the current bid or lower will not be a given. It will also cost Microsoft at least another four months, during which time Yahoo talent will continue to leave and Microsoft will fall farther behind. A Yahoo-Google search deal could also be implemented during this period, which could give Yahoo shareholders even more cause to demand a price increase.

Walk away. Possible, but a last resort. We think this will only happen after a private price increase (see below).

Raise bid, publicly or private. A public price increase is unlikely but we think private is the most-likely outcome. We think Microsoft will authorize its bankers to tell Yahoo's bankers that, thanks to Yahoo's strong performance in the quarter, Microsoft is now willing to pay more--if Yahoo comes to the table and a deal agreement can be reached rapidly. We suspect this implied increase will be at least a few dollars a share ($1 or $2 is almost an insult). We suspect Yahoo will take this seriously and will sit down and begin to try to hammer out a deal.

Again, we think a strong Yahoo earnings report changes the power-balance here, especially given the overhanging threat of a Yahoo-Google search deal. We think it will be tougher for Microsoft to fight and win a proxy battle, and we think the four months of uncertainty and wasted time necessary are a major discincentive to go this route. A strong Yahoo earnings report will give Microsoft a good, face-saving excuse to raise its price, and we expect it will will privately go this route. We think a strong earnings report effectively takes a Microsoft price cut off the table.

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Yahoo-Microsoft: Playing the Yahoo Earnings Chess Game

Tomorrow's Yahoo's earnings report will change the balance of power in the Microsoft negotiations. If the report is bad, Yahoo will be forced to sell at any price. It the report is strong, we think Microsoft will privately raise its bid, so the companies can reach a friendly deal quickly.